| 2011 | 2012 | ||||||
| Price: | 9.90 | EPS | $0.00 | $0.00 | |||
| Shares Out. (in M): | 19 | P/E | 0.0x | 0.0x | |||
| Market Cap (in $M): | 191 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | 78 | EBIT | 0 | 0 | |||
| TEV (in $M): | 269 | TEV/EBIT | 0.0x | 0.0x | |||
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Stewart Information Services (STC)
Stewart Information Services is a US company that provides title insurance and information services required for settlement by the real estate and mortgage industries. Stewart has been written up before on VIC but the president’s newly revised Home Affordable Refinance Program or (HARP) could lead to an extra ?.30 to ?.60 per share for 2012 and it provides a great near term catalyst that begs for STC to be revisited. The company is a great candidate for value because it doesn’t conduct quarterly conference calls, and it has little sell-side research coverage. As a result, STC is largely ignored and underappreciated by the market. Though its business is tied to housing transaction volume, no housing recovery is necessary for STC to be a great value at this level because it is largely a story of right sizing fixed cost structure, taking advantage of new market dynamics with their independent agents and of allowing past losses to flow through the income statement.
In order to understand STC, you have to understand the title insurance industry. Title insurance protects lenders and buyers of residential and commercial real estate against defects in the title of purchased land. Unlike other types of insurance, title insurance protects the insured against acts or omissions that occurred prior to the execution of the policy as opposed to other forms of insurance that provide protection against losses that may arise out of events in the future. For instance, if an unpaid carpenter or local taxing authority placed a lien on a home clouding the title to the property or someone sells a parcel of commercial property that they do not actually own, then the title insurance company will be liable for any damages suffered by the buyer or lender as a result.
In practice, losses are quite rare in the title insurance business and they typically average only about 5% of total premiums. This is in contrast to typical homeowner or auto insurance where about 80% of premiums are paid out for losses. Despite the small portion of premiums that go to cover claims, title insurance companies must pay agents anywhere from 70-90% of premiums to perform title searches, examine title records prior to issuing a policy and to conduct the closing. As a result, industry underwriting margins tend to fluctuate between 5% and 10%, which is comparable to typical P&C insurers.
However, since 2007 profits have been very week as title insurance company revenues are directly tied to both transaction volumes and real estate prices. As a result of the real estate crisis that began in 2007, title insurance revenues fell almost 50% from 2006 to 2009. At the same time, title insurance companies have significant fixed costs in the form of title examiners, lawyers, in-house database (title plant) managers and closing agents. With all of these fixed costs, profits declined in excess of the decline in revenues and the entire industry suffered significant losses during the period.
As a result of the pressure on the market, the third largest title company, LandAmerica, was facing bankruptcy. In order to avoid bankruptcy court, LandAmerica agreed to be purchased by Fidelity National (FNF), creating the largest title insurance company with over 46% market share. Following the acquisition, FNF slashed costs, closed the corporate headquarters, consolidated offices and eliminated under-performing or redundant agents. After FNF was finished, it fired 40% of LandAmerica’s workforce.
Recently, other title companies in the industry have benefited as banks have reduced the market concentration of the combined company. Also, due to increased concentration in the industry, pricing is less competitive leading to higher margin business. Furthermore, industry consolidation has also led to significant improvement in the bargaining power of title companies versus their affiliated independent agents.
2011 US Title Insurance Market Concentration
Stewart Title is now the third largest title company in the country. It is a family-controlled business and has historically been one of the less well run title insurers with historic average operating margins of around 5% to 6%. In contrast, FAF’s long run operating margins are in excess of 10%. Nonetheless, we anticipate that STC’s future margins can actually exceed those it maintained in the past because of its improved cost structure, the development of its real estate information services (REI) business and industry wide changes that will enable STC to receive a larger share of premiums from its independent agents.
Profit Driver # 1: Lower Loss Ratios.
During real estate crash of 2006-2009, title losses for STC rose to a peek of over 13% of premiums as a result of sloppy underwriting and significant defalcation on the part of independent agents. These losses lag the implementation of more stringent underwriting policies because claims on poorly written policies take time to be discovered, processed and work their way through the income statement. These claims started to decline from their peak in the 3rd quarter of 2009 at 12.3% to 9.6% for all of 2010 and 9% in the 3rd quarter of 2010. STC’s management has expressed that they are confident that claims will fall to back to 5% by the end of 2012. This makes sense because all of the claims that arose out of the boom have to feed through the income over several years as they are discovered but they eventually taper off to a normal level. Based on our research and the historic claims that were made prior to the crisis we think that claims should comfortably be able to reach management’s 5% target as most of the claims that could be made based on policies written prior to the crash will have cycled through the income statement.
Profit Driver # 2: Better Retention Rates with Independent Agents.
STC should also benefit from an improvement in its allocation of premiums from independent agents. Historically, STC received approximately 17% of all premiums generated by independent agents. Now that there has been a significant consolidation among title insurance companies the percentage of premiums retained by independent agents has been significantly reduced industry wide. This is because independent agents have lost bargaining power since the recent industry consolidation. In 2010, STC managed to receive 18% of independent agent generated premiums and we anticipate they will continue to receive a larger share until they reach 20% in 2012.
Profit Driver # 3: New Business for Real Estate Information Services.
Finally, STC should continue to benefit from growth in its Real Estate Information (REI) business. Its REI business provides lender services, on-line filing and transaction services. STC built this largely from the ground up following the financial crisis. Included in its lender services, STC offers loss mitigation, loan modification and other post-closing services to banks such as REO and short-sale assistance. This business is a significant beneficiary of loan modification and default management and the eventual disposition of bank foreclosed property. However, STC has made the business decision not assist with any foreclosures because they consider it to be a political hot button (e.g. the Robo-signing scandal). The significant backlog of delinquent home mortgages and foreclosures have led to extraordinary growth in this business. Revenues for the REI business grew organically in 2010 by over 40% from $57 million in 2009 to about $81 and are currently on pace to do around $100 million (aided by a recent acquisition). Year to date this business has generated about $34 million of EBIT. Over 4 million homes will have to go through either a short sale or a REO and STC has about 15% market share for that market. They will be able to recieve about a 1% commission for each of the the homes sold which should lead to about $600 million in revenue for STC over 4 years (4 million homes X $100,000 home price X 15% STC market share X 1% commission).
Based on hosing sale estimates provided by MBIA, Fannie Mae and Freddie Mac, we anticipate that STC’s title revenues for 2013 will be approximately $1.60 billion which is slightly more than title revenues for 2010 of $1.55 billion. The title revenues would be split between the 40% Direct Operations (conducted by STC in-house agents) and 60% Independent Agency Operations (conducted by third-party agents subject to retention).
2013 Estimate (based on 5% Title losses and 20% Retention Rate with no inclusion for HARP and no housing recovery)
Direct Operations Revenue: $ 640,000
Independent Agency Revenue: $ 960,000
Total Title Revenue $ 1,600,000
Investment Income $ 16,000
REI Business (assuming no additional growth) $ 100,000
Total Revenues $ 1,716,000
Amounts retained by Agencies (80% or 20% retention rate) $ 768,000
Employee Costs $ 480,000
Other Operating Costs $ 260,000
D&A $ 20,000
Title Losses (5%) $ 80,000
Interest $ 4,500
Total Expenses $ 1,612,500
Minority interest $ 12,000
EBIT (less minority interest) $ 91,500
Taxes $ 34,770
Net Income $ 56,730
Number of Shares outstanding 19,298
Earnings Per Share $ 2.94
That would mean that at $10 STC is trading at about 3.3X 2013 EPS
Profit Driver # 4: HARP
The icing on the cake and a more immediate catalyst for STC are the modifications that President Obama announced for the Modified Home Affordable Refinance Program or (HARP). This is one of the many programs that have previously been announced as a means to provide support to the housing market that never really achieved much traction. Originally, HARP provided that people who were underwater on their mortgages could refinance as long as they were current on their mortgage and the mortgage was not of greater than 125% of the market value of the house. The original HARP went on to require the banks to include certain representations and warranties that would allow Fannie and Freddie to put the house back to the bank if the borrower defaulted. Of course, this created a disincentive for the bank to find that people were eligible for the HARP program.
Fast forward to today. Housing prices have been falling again and the election is one year away. The president is trying to do everything he can to provide support to the economy from opening up the Strategic Petroleum Reserve, providing relief for student loans and amending the HARP program. Now, under the current HARP, a borrower needs only to be current on their payments and they can refinance without an appraisal and a lot of extra pesky underwriting requirements and there is no ability for Fannie and Freddie to put back the house to the bank if the borrowers ultimately don’t pay. This program is due to start January 1, 2012.
CoreLogic estimates that as many as 20 million home owners could qualify – one out of every four in the country. Qualified borrowers are likely to pursue this because they could reduce their monthly mortgages by around $400 per month. The banks will be able to collect fees buddle up the mortgages and provide the refinancing without any risk of a put back from Fannie and Freddie.
Economists with the government estimate that 1 to 1.6 million homes will be refinanced under the modified HARP program. With the median home price at around $150,000 the program should lead to anywhere from $150 to $240 million of additional refinancing for next year. Prior to this announcement, Fannie Mae had forecast 2012 residential lending to be $958 billion comprised of $467 purchase volume and $491 billion refinance. This amount will likely be increased by 15-25% by the HARP program which should lead to a significant boost for all title insurers as each refinancing requires a new title policy. For STC, this could mean an additional $200-$400 million in title revenue and $10-$20 million in additional EBIT or an additional $.30 - $.60 per share.
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